Yglesias » Monetary Policy and Asset Prices

Yglesias » Monetary Policy and Asset Prices:

I was arguing yesterday that 25 years worth of wage stagnation, occasional recessions, and no episodes of inflation together constitute a powerful prima facie argument that monetary policy has been systematically too tight. That doesn’t necessarily mean it’s been dramatically too tight or anything. Maybe it’s just that interest rates should have been 0.25 percentage points lower from 1985 onwards. That would still make a big difference over time.

Something some people said in response is that we may not have had CPI inflation, but loose money might drive asset price bubbles. People say this fairly frequently, but I don’t understand how it’s supposed to work. I’ve seen several efforts to debunk the loose money = bubbles hypothesis via empirical work (PDF, for example), but I also think it’s very problematic as a theory. After all, what does it mean to say there’s a “bubble” in the price of houses or the price of tech stocks? It means, I think, that current prices are based on overestimating the long-run demand for homes or for the goods sold by tech firms.

Clearly, things like that do happen from time to time. But how would higher interest rates avoid those occurrences? It’s easy to see how tighter money could lead to lower asset prices via slower growth and reduced demand and expectations of demand. But that doesn’t eliminate the “bubble,” the mismatch between anticipated demand and actual demand, instead it lowers the price of the asset by actually lowering demand.

Bubbles, it seems to me, have to do with the fact that (a) making correct estimates is hard, (b) frailties of human psychology, (c) certain “the market can stay rational longer than you can stay liquid” asymmetries, and (d) to an extent bad regulatory incentives. Making money tighter or looser should alter the average price of assets but there’s no reason to think it would change the basic social and psychological dynamics that sometimes lead to large-scale mis-pricing.